Not all venture capital is the same

Or how the origin of venture capital changes its effect

Many big-name companies such as Apple, Rovio (of Angry Birds fame), Spotify, Facebook, Google, Microsoft and Starbucks would never have existed, or certainly never have grown so big, without venture capital. “Venture capital is vitally important for start-up companies that have an idea or perhaps even a prototype, but often no finished product that they can put onto the market,” explains David Devigne, whose doctoral research under Sophie Manigart, professor and expert in venture capital, investigated cross-border venture capitalists and their portfolio companies in Europe. This research has shown that businesses need to think carefully about which financier they take on board. This is because the origin of the capital affects the company’s success.

What is venture capital and where does it come from?

Between 2000 and 2010, venture capitalists invested 79 billion euros in 18,000 promising European businesses. What is striking is that an increasing proportion of that amount (28%, in fact) originates with foreign players. Venture capital is highly diverse, but it is always a question of short-term, usually risky investment in young, often high-tech companies looking for financing that will allow them to grow. In Belgium, typical examples might be Omega Pharma, Thrombogenics, Option, Materialise, Clear2Pay, Telenet, Transics or Biocartis when they were just starting out.

David Devigne: “The money usually comes from investors who give venture capitalists the task of searching on their behalf for interesting companies that offer the prospect of high profits. Some companies are new start-ups and others are already further down the line. It is not a passive process. Venture capitalists actively support the portfolio company with advice and practical assistance, and if things go well the two parties go their separate ways after an average of five to seven years with considerably increased value.”

Big difference between local and international players

There are three types of venture capitalists. You have domestic players that are based entirely locally, in the same country as the start-up. Then you have cross-border investors who manage everything from abroad. And finally there are also international players who provide branch venture capital. They either have their own local branch or work together as co-investors with other domestic players. David has discovered that these origins are not unimportant.

In his PhD, he studied the effect of origin on three aspects of the investment cycle:

1. the selection process
2. company growth, i.e. growth in total assets, employee numbers and turnover
3. the point at which the venture capitalist leaves the company

The perfect match between investment and business

Previous research has shown that international players tend to go for companies that are more mature and consequently less risky. After all, the distance between the investor and the company is greater, which makes it more difficult to follow up the company closely. However the doctoral research has shown that when international and domestic players join forces, they do invest more in high-risk start-ups.

“Domestic players, in the wider sense of the term, can solve that problem for an international player operating from abroad. I am talking about both purely domestic players and local branches of international players here. It is actually a way to get the best of both worlds. Belgian companies often attract less money, less often than other European companies, and certainly much less than they would in the US. However that is not the case when international venture capitalists get involved.”

Besides the difference in the amount of financing, venture capitalists also offer added value to the companies they invest in. “They give advice, attract key employees and set up contacts with potential customers and suppliers. In other words, they help with the practical side of starting up a business,” David explains. “Therefore the extent to which the venture capitalist knows or does not know the local start-up market has a clear effect on the results of the investment. A domestic player knows the local market very well and can help the company considerably in the start-up phase with its knowledge of local laws, recruitment, financing, customers, suppliers etc.” In this initial phase, then, a domestic player is beneficial, but it does need to be someone with a good reputation and a large network, as well as someone who can introduce international players further down the line.

As we know, venture capital is often linked to high-tech companies. These producers of niche products rapidly outgrow the Belgian and even European market and need to operate on a global scale, David explains. “International players have different knowledge, another domestic market and different potential markets for sales. They can signify quality. If you approach the American market with an American investor, you already have an advantage over your competitors.”

Company growth

A company that only takes local investors on board will grow rapidly, but this growth will flatten out after about four or five years. If you start out with only cross-border investors, growth will initially be slower but more persistent. With a combination of domestic cross-border venture capital, you will not only grow quickly but you will be able to maintain that growth over a longer period of time. David: “This makes it essential to be sure that you take a local player on board. An international player only becomes important in the long term, so you do not need to approach an international player right from the start.”

Exit: what if it goes wrong?

“There are a very large number of failures,” says David. “About 30 to 40 per cent of these young or start-up companies go bankrupt, precisely because the risk is so high. When they attract investment these companies often do not yet even have a product. They are highly innovative, but there is a lot that can go wrong in scaling up from a prototype to a marketable product: production turns out not to be profitable, there is insufficient demand, or better or cheaper technologies exist. An extreme example is biotech companies, where it takes ten years of development and clinical trials to determine whether the medicine developed is safe and effective.”

So what has research shown? If signs appear that things are going wrong, domestic players are more often prepared to make new investments. The reason is that they are deeply rooted in the local community: the investor knows the business personally and has access to ‘soft’ information that is far more difficult to interpret. A cross-border investor is often far more distant from the company and tends to base its decisions more often on pure, hard figures.

And what about international players that invest from their own domestic branch? You would expect them to behave like purely domestic players, but surprisingly that is not the case. The investment committee mainly looks at the hard facts because it is composed of both local and international managers.

David’s conclusion? “Both local and international players have their specific pros and cons, but if it is at all possible, it is better to take both on board together.”

Source: “International Venture Capital Investors and their Portfolio Companies in Europe”. PhD thesis by David Devigne. Promoter: Prof. Sophie Manigart.

& Rankings

Equis Association of MBAs AACSB Financial Times